The Federal Reserve is likely to announce the start of its highly anticipated easing cycle this week, however, the rate cut in the coming months may be lower than market expectations.

Some major investors and analysts believe that due to the continued strength of the economy, the current rate cut cycle by the Federal Reserve may keep interest rates relatively high, indicating that substantial rate cuts would only make sense in the event of a future economic downturn.

Former head of Pacific Investment Management Company (PIMCO), Mohamed El-Erian, focused on bonds, expressed in an email: "My sense is that the market's expectations for the Fed's rate cuts exceed the comfort zone of most Fed officials and economists."

The debate over whether the Federal Reserve will cut rates by 50 basis points or 25 basis points this week continues, with the market leaning towards a larger rate cut, which could sow the seeds of turmoil.

In addition to announcing the interest rate decision, the Federal Reserve will also update its forecasts for future rate cuts. In the latest forecast in June, Fed officials estimated the long-term “neutral” interest rate to be 2.8%.

Investors expect the Federal Reserve to cut rates by about 240 basis points by the end of next year, reducing the federal funds rate from the current range of 5.25%-5.5% to around 3%. Apollo Global Management's Chief Economist, Torsten Slok, stated that such a rapid rate cut would signal an economic recession.

Slok stated in a report on Tuesday: "While surveys indicate that the market widely expects a soft landing for the economy, the interest rate market prices in a full-blown recession."

Due to the expected decrease in interest rates, the yield on the two-year US Treasury bonds has dropped by about 140 basis points from its peak in April 2024, closing at 3.61% on Tuesday. This means that the bond market expects the average interest rate for the next two years to reach this level.

"The bond market has already absorbed a significant amount of rate cuts from now until next year, which is a very aggressive situation," said John Madziyire, head of US Treasuries and Treasury Inflation-Protected Securities (TIPS) at Vanguard. "To achieve this goal, we need to see a scenario of a significant economic slowdown."

Wei Li, Chief Investment Strategist at BlackRock Investment Institute, believes that as the market prices in continued inflationary pressures, short-term US Treasury bond yields will rebound.

"The market has effectively digested a series of rate cuts by the Federal Reserve, a pace of rate cuts that typically only occurs in response to economic recessions, but recent data indicate more of an economic slowdown than a recession," Li said. "We believe the Fed will not significantly cut rates, nor will it do so quickly."

Senior Rate Strategist Ed Al-Hussainy of Columbia Threadneedle states that healthy corporate earnings and a stable labor market do not seem to validate the market's expectation of substantial tax cuts.

Hussainy believes that market expectations are out of sync with the economic health. He points out, "Corporate default rates are very low, profit growth is very healthy, all of which are related to the labor market and overall growth."

Investors say that a shallower rate-cut cycle will resemble the 1990s, when, in a growing economy, despite a robust job market, inflation remained a concern for the Federal Reserve.

In contrast, during the deeper rate-cut cycles in 2007 and 2008, the Federal Reserve aggressively cut rates to address economic slowdown and the eventual financial crisis.

The repricing of the Fed's rate cut prospects by the market does not necessarily spell doom for investors.

The futures market widely expects the Fed to begin cutting interest rates in the spring of 2024. Despite these rate cuts not materializing, the s&p 500 index continues to rise, led by strong performance of large-cap technology stocks related to ai.

Vishal Khanduja, co-head of Global Fixed Income at Morgan Stanley Investment Management, said: "We are quite confident... economic growth is slowing down, but the anti-inflation trend remains intact."

Editor/Lambor